I’ve been ruminating for a few days on this post by Brad DeLong defending Larry Summers. Here is Brad’s version: Summers (and Brad himself) welcomed the massive leverage taken on by the trading houses, since this would serve to shift money from the hands of risk averse small savers to large risk-accepting institutions. Since returns to the first group are historically much lower than to the second, this should lead to faster economic growth. The unforeseen flaw proved to be the inability of the Fed, this time around, to clean up the mess when some of the risky bets soured. This was understandable, says Brad, because the Fed had been able to do the job repeatedly in the past. If the Fed had been able to tidy things up properly in 2007-08, we would have been able to return to a higher-risk, higher-growth trajectory, and all would have been well.
In order to understand the deeper assumptions on which Brad’s argument depends, and to see why it should be called a “finance perspective”, we need to deconstruct this crucial word, risk.
Risk, as Brad and Larry see it, is about the variability of returns, the building block of modern financial models. With more variability comes an increased likelihood of episodes in which losses are bunched, so it is necessary to have a player, like the Fed, who can steer us through them. Otherwise, there is little social cost (as opposed to the private costs of the liquidity-constrained) to shifting the allocation of investable funds from the those with a low tolerance for beta to those with a high tolerance.
This would be a reasonable assessment, if the risk Brad refers to is the risk that brought down the global economy, but it wasn’t. The financial crisis that triggered the crash was not the result of a random stochastic swing, or not primarily. It was due to the accumulation of multiple risks that are real and visible, although not present in financial models. What were they?
In no particular order, here are a few:
1. Global systemic risk (aka global imbalances). Huge, persistent current account deficits were financed by unsustainable accumulations of debt, not only in the US but also in the peripheral European countries that are now under the gun. Since the debts are denominated in reserve currencies (dollars and euros), they did not trigger forex crises, which might have relieved them, if in a disorderly way. Instead, the process continued until the borrowers were simply unable to service, once the bubble dynamics (refinance through asset appreciation) came to a sudden stop.
2. Bubble dynamics. Housing bubbles inflated in the deficit countries in broad daylight. It should have been obvious that when the bubbles popped, a large amount of paper would have to be repriced, and this in turn posed risks for financial institutions. What we didn’t realize until too late was that a mountain of derivatives had been built on top of the original bubble-prone assets, and that they had infiltrated portfolios everywhere.
3. Institutional failure. The current crisis has exposed shoddy behavior in all corners of the system. Mortgage originators threw out all standards and saddled vulnerable borrowers, disproportionately minority, with unserviceable debts. They misrepresented the assets they transferred to the banks, and the banks didn’t care, because they were packaging them to sell. Rating agencies didn’t care. Regulators didn’t care. Cynicism was universal. One of the eternal lessons of markets—all markets—is that the unraveling of behavioral standards is a significant risk whenever the financial returns to deception are large and the institutions of monitoring and control are weak.
4. Distributional effects. During the era of de facto deregulation, the US financial sector metastasized and raked in half of all corporate profits. On the eve of the crash, the average compensation for workers—all of them—in this sector had reached $100,000, and this does not include bonuses, which were estimated to average $200,000 each (although not all employees received them). In other words, the financial sector alone accounted for a noticeable portion of the overall increase in income inequality, which in turn caused many hard-pressed households to substitute credit for income in order to maintain living standards. The gross inequalities of the last few decades—megaprofits for a few and stagnation for the many—have been risky.
These risks, in conjunction with excessive leverage in the financial sector, crashed the economy. Most of them, however, play no role in the category of “risk” as it appears in financial models. What’s going on here?
In my opinion, this leads us to a deeper, cultural level. Risk in its narrow financial sense is abstract and disembodied. It pertains to no specific industry, practice or moment in history. It has no particular context; it applies to every activity in general and none in particular. In other words, it is a typical product of the information revolution of the twentieth century, the intellectual shift that gave us digital communications, genetic sequencing, and, of course, the computer. It is based on the notion that standardized bits of information can be extracted from any actual entity or event, and that the manipulation of these bits can achieve almost any goal for the system from which they were extracted. A useful metaphor is the container revolution in shipping. The container is abstract and universal, the same unit no matter what or how much it holds. Container logistics is essentially unrelated to the specifics of who is shipping what. Financial flows are the containers of economics; it is the function of finance, as the sector that controls these containers, to regulate the entire system algorithmically.
This view of the world as being reducible to disembodied information is widespread among the highly educated, especially if they are conversant with digital technology. Actually, Brad puts it better than he realizes: “....the most powerful lobe of my brain is the one that is always running an instantiation of the Larry Summers thought emulation module on top of its native wetware code.” Exactly.
It is possible to be an adherent of the disembodied-information-school-of-almost-reality without being a believer in finance as the rational control center of a modern economy, but in practice the first eases the way toward the second. Why should we worry about whether a mortgage monger in Cleveland has fudged the paperwork on a house that’s been flipped to a laid-off machinist, when the whole system can be optimized by tweaking the way “risk” is priced and allocated by financial markets?
And that, of course, leads to the question about self-interest, which has also been part of the Summers story. What difference does it make that economists who touted the wonders of deregulated finance were also handsomely rewarded by the financiers? Surely they don’t tailor their economic views to their bank accounts, do they?
My guess is that Summers, like the others who cashed in during the boom (and may be re-cashing today), really, truly believes that the people who have made him rich are doing the Lord’s work. Finance, for him, remains the command center of economic life, and it is necessary that smart people operate these controls and are given the latitude to get the job done. As is usually the case with ideology, it isn’t possible to disentangle the intellectual sources of belief from those of expediency.
As for the rest of us, I hope we realize that a principal goal of economic reform should be to shrink finance. There should be a much smaller financial sector, and it should make a lot less money. Its size and wealth are out of all proportion to its actual contribution to the actual economies we inhabit. This is not a “luddite” call to eliminate sophisticated methods of pricing assets and moving money. A dynamic economy depends, as it always has, on the ability to move resources from where they are earned to where they are needed. But return once again to the container revolution: it has vastly improved shipping, but shipping (fortunately) remains a small part of overall economic life. Most of the employment and earnings belong to those who make or sell stuff, if not in the most equitable way, and the folks who move it from point A to point B are a small part of the story.